The framework of everything can change dramatically. Something similar is happening now to investing.
Investments once conformed to easy-to-understand rules. Valuation relied on cash flows, earnings and other fundamental factors. Price anomalies generally corrected to somewhere near a consensus equilibrium. But over the past couple of decades those rules have broken down.
Traditional investing requires truthful and accurate data, both at a macro-economic and business level. Yet nowadays official economic data is often contradictory. Employment and inflation depend on the measure. They are subject to significant revisions and methodology changes.
Accounting rules designed to improve disclosure have made it difficult to interpret performance. The practice of GAAP and non-GAAP reporting produces confusing and different outcomes for stock-based compensation and acquisitions. Derivative accounting and off-balance sheet rules necessitate retaining an accountant to understand earnings and balance sheets.
Significant parts of the economy are now privately owned, providing limited information. A large proportion of companies are unprofitable, relying on dubious metrics such as “eyeballs view,” “page clicks” or “total addressable market” to establish value. Asset-lite firms are dominated by difficult to assess intangible assets, including software and brands.
Conventional investing relies on predictable policy frameworks. Increasing politicization and an emphasis on geopolitics complicates matters. Sanctions and subsidies seek to further non-financial agendas, often at economic cost. Sectors such as renewable energy, electric vehicles and their suppliers have benefitted from government support. Yet with each new government seeking to implement its own agenda, policy longevity is non-existent, making planning difficult.
Traditional investing also assumes diversity across asset classes. Traditional stock holders and different fund types, index private-equity and specialist sector funds all simultaneously hold the same underlying business exposure, reducing diversification.
“ Markets are increasingly driven by common factors, primarily monetary policy. ”
Markets are increasingly driven by common factors, primarily monetary policy. Large central-bank holdings of securities, in some cases like Japan and Switzerland including equities, influence demand. This distorts funding costs, volatility and correlations. The portion of price movements that can be explained by macro-policies rather than business fundamentals has grown. Many highly valued start-ups and technology firms, many with no viable path to profitability, have benefitted disproportionately from abundant and cheap capital.
Distorted markets result in crowded trades and similar investment strategies. The shrinking universe of investible securities due to mergers and acquisitions and the rise of private markets increases concentration. Corporate share buybacks, with companies seeking to optimize earnings per share, compound the problem.
Artificial prices and increased exposure to specific events, such as to a policy change, alters risk. It is aggravated by diminishing liquidity, resulting from decreased market-making capacity due to onerous regulatory requirements and the fact that many participants, particularly algorithmic traders, are actually users, not providers, of liquidity in volatile periods.
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These failures make investment markets less predictable. The concept of risk-on/ risk-off investing epitomizes the phenomenon, with investors expected to purchase risky securities in benign conditions and retreat to safety when conditions change. It encourages speculation and fads ranging from dot-com stocks, real estate, social media, meme shares and now artificial intelligence. It relies on low cost of capital and the expectation of central bank support in case of the risk of financial instability.
Navigating the new
How does an investor navigate these conditions? Certain principles are useful:
First, investment regimes can coexist. In a classical environment, traditional methods of analysis, price and value may be useful. At other times, the operative investment principle might be to have what others are having. Investors would do well to identify the type of market regime they’re in.
Second, opportunistic investing is necessary. The traditional set-and-forget approach of “stocks for the long run” may be inappropriate. Nimbleness and a certain frugality in return expectations, taking profits early and cutting losses, may be advantageous.
Third, income-generating assets are to be preferred as cash-flow streams meet life’s needs, avoiding forced selling and providing a cushion from downturns.
Fourth, careful risk management and a focus on liquidity is needed. Outliers — large up- and down-tail movements — are likely to be more frequent, creating outsized gains and losses quickly. An underestimated problem is the ability to trade. Liquidity conditions are fragile and inability to adjust holdings may prove costly.
Fifth, leverage and open-ended exposure like selling options may prove ill-advised.
All investing is a mix of skill and luck, with perhaps a greater weighting of the latter than even the most successful are willing to admit. Author Fred Schwed’s advice in Where are the Customer’s Yachts? is sage: “All of these theories are true part of the time; none of them true all of the time. They are, therefore, dangerous, though sometimes useful.”
Satyajit Das is a former banker and author of A Banquet of Consequences – Reloaded ( 2021) and Fortunes Fools: Australia’s Choices (March 2022).
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